Is it time to buy emerging markets?

This article appeared in the July 2014 ASX Investor Update
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Adding exposure to developing countries should be considered, depending on your risk appetite.

By Jon Reilly, Implemented Portfolios

Countries included under the broad category of emerging markets can vary depending on who is responsible for the definition. Official organisations such as the International Monetary Fund and the World Bank have their own definitions, but for investors it is important to look to those set by the major index companies.

Even then there are subtle differences between index providers, which are important to understand and the constituents and parameters are readily available. For example, one index provider assesses countries on economic development, the size and liquidity of their investment market, and accessibility for investors.

Exchange-traded funds (ETFs) are a popular way to access these investments, and those that track the MSCI Emerging Markets Index have attracted the most money from investors. This index provides exposure to listed companies in 23 countries, the most dominant being China, South Korea, Taiwan and Brazil. Combined, they represent a little over half the index's holdings.

Samsung Electronics and Hyundai Motors are probably the most familiar to Australian investors, but they are just two among more than 800 companies that comprise the MSCI Emerging Markets Index, providing investors with a highly diversified exposure.

Well-chosen emerging markets exposure can boost returns

There are also active fund managers that apply their expertise to emerging markets by constructing portfolios that are much more concentrated than the broad index of emerging market stocks. As is the case with other asset classes, there are varying degrees of success among managers in this sector when it comes to adding value from active stock selection, and specifically their ability to consistently beat the underlying index.

Investors, who undertake the extra research to truly gain an understanding of the manager's process and potential competitive advantage, can be rewarded with outperformance. However, this is hard to get right consistently, and just as for other asset classes and sectors, for many investors it is prudent to utilise the low-cost, broadly diversified index exposures offered by ETFs for at least part of their portfolio.

The range of ETFs on ASX can be used to focus exposures to particular countries within emerging markets, either collectively or individually. For example, the term BRIC was coined in 2001 to describe Brazil, Russia, India and China and there is an ASX-listed ETF that will simply and efficiently provide exposure to more than 300 companies in those countries.

However, the differing economic and investment market experiences of those four countries in the intervening period shows a need for investors to consider being more selective than these broad country definitions.

We saw a good example of how countries within emerging markets can behave differently in 2013, with the first signals from the US Federal Reserve that the Fed would adjust its monetary policy. Emerging markets countries such as India and Indonesia that had current account deficits saw sharp contractions as investors thought they would suffer when the international money they rely on to fund economic growth may not have been as readily available.

By contrast, countries such as China and South Korea that have current account surpluses saw no such disruption. Several of these countries are currently available to investors via ASX-listed ETFs, and with investor demand we can be confident the range of ETFs will expand in coming years.

Understanding 'frontier markets'

One area also attracting attention is so-called frontier markets, which are defined on similar criteria to emerging markets but with lower thresholds for size and market liquidity. We do not currently have a local ETF option to gain frontier market exposure, but these have been in place for several years in overseas markets, mainly providing access to companies listed in the Middle East and Africa, with small exposures to parts of Asia, Latin America and Europe.

Together, Kuwait, Qatar and the United Arab Emirates represent half the frontier markets, and there is a significant concentration in Financials (approximately 55 per cent of exposure). Frontier markets are perhaps one area to just watch from the sidelines for the time being, but there are potentially exciting longer-term prospects.

Are emerging markets good value?

With an understanding of the landscape, let us turn to the question of is now a good time for investors to increase exposure to emerging markets? This is a fundamental portfolio construction issue, and investors need to have a reliable process in place to identify attractive times to increase exposure and, equally as important, appropriate times to reduce it.

For many investors this may simply be an either/or decision within their allocation to international equities - that is, to invest in either developed markets such as the United States, Europe and Japan, or emerging markets.

The reality is that there really is no consensus and no definitive answer to the question. This was evident at a conference in May in the United States, when among a panel of chief investment strategists, one said valuations in emerging markets were compelling and warranted increasing exposure, and another said they were advising clients to exit emerging markets and reinvest proceeds in US shares. No doubt each would have been able to support their view with dozens of slides and argued their position with conviction.

As with most investing questions, the true answer is "it depends". If your risk profile and subsequent asset allocation strategy says that an exposure to international equities is appropriate, then a case can certainly be made that at least some of that exposure should be in emerging markets. Managing your asset allocation, either across asset classes or within, is critical to long-term portfolio management and when done systematically will lead to better portfolio outcomes.

In simple terms, this means applying a disciplined approach that, other things being equal, gradually reduces exposure to investments that have performed very strongly and hence have become relatively more expensive, while adding to exposures that have underperformed and provide better value, such as emerging markets.

To pick two countries as examples within international equities, there has been a stark contrast between the recent performances of the United States and China. Looking at local currency returns, the ASX-listed China ETF has been flat over three years and down slightly over five, compared with the S&P500 ETF, which has provided annualised returns of 20 per cent and 15 per cent over the same two periods.

All too frequently we see money from investors' portfolios moves to investments with recent strong performance, rather than to investments that look historically cheap - and experience tells us that leads to poor outcomes eventually. Valuation is not, however, a market timing tool, which means you probably, will still have to be patient, just as emerging markets investors have had to be for several years now.

So, although the answer is still "it depends", adding exposure to emerging markets is something that should definitely be considered in your portfolio now and at regular intervals in the future.

ETFs and ETPs has useful information on the features, benefits and risks of these products.

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